Wednesday, January 23, 2013

On 16th January 2013, speaking at an outreach
programme of the Reserve Bank of India (RBI) at Lalpur Karauta village in the state of Uttar Pradesh, India, Governor Dr. D. Subbarao said this: "If you see the
currency note, it is printed on it that 'I promise to pay the bearer the sum of
Rs 100' and it has my signature as the RBI Governor. What does the promise and
signature mean? It means that the RBI will control inflation and maintain its
purchasing power". It is another matter that the stream of journalists
present did not report this very important statement (see here, for
example) when they filed their reports on the event. Either they did not really
understand what the Governor said, or did not like what they heard.

If you read the pink press regularly, or watch one of those stock market channels
masquerading as ‘business’ channels, you might be forgiven to think that the RBI
Governor sits in his office holding a magic wand in his hand. All he needs to do is to
waive the wand lower, and lo! All the country’s economic problems would be solved!
This magic wand, the press might tell you, is called The Interest Rate. So much
is the pressure from interested politicians, crony capitalists and the media on the
Central Bank to reduce rates, that one would be inclined to believe that that’s
all that is there to managing an economy.

Subbarao has a promise to keep - to maintain the purchasing power of our money

The truth however, is not so
simple. When it comes to the interest rates, the mainstream
media is not just wrong, it is preaching exactly the opposite. Let us
therefore be clear – beginning to reduce interest rates right now will take the
country on the path of ruin.

Let us understand why I am saying interest rates need to be raised.

Inflation is still running frighteningly high. As per the latest figures, Consumer Price inflation (CPI) is at
10.56 % per annum. Food prices have increased by 13.04 %, with several key ingredients such as
oils & fats (16.73 %), vegetables (25.71 %), sugar (13.55 %) rising at a
much faster pace. Being official figures, even these figures may be grossly
understated. Prices of several items have as much as doubled in the past year. The index does not even include the dramatic increase in the prices of services
like transport and education.

Bank lending is already growing
faster than deposits. For deposits to catch up, interest rates need to be raised. RBI has
pointed this out in the last mid-quarter monetary policy review on 18th December 2012. In December, borrowings from RBI’s LAF (Liquidity Adjustment Facility) reached
highest level for the year at Rs.1.70 lakh crore and are still running high at almost Rs. 80,000 - 1 lakh crore this month (see this or this).
To put it simply, banks as a whole are lending more than what their deposit
base justifies.

The high rate of inflation and
the shortage of deposits with banks clearly point to a need to raise, and not
lower interest rates. Even the slight dip in wholesale inflation rate (WPI) from 7.24 % to 7.18 % that is being bandied around is far higher than RBI's 'comfort level' of 4 - 5 %.

Lowering interest rates ignores the interests of savers completely; it presupposes that borrowers are
the only ones interested in interest rates. Lowering interest rates punishes
savers, rewards borrowers and encourages profligacy. An economy should be built
on solid foundations of high savings rate, and not on high borrowings. If savings
are high, plenty of money will be available for productive investment, and this
in turn will cause rates to move lower. Low interest rates are thus an outcome of a healthy economy, lowering rates artificially cannot automatically lead to a healthy economy.

In its Financial Stability Report
released last month, the RBI has stated that low real interest rates are
causing diversion of savings to hard assets like property and gold. Lowering rates further will worsen this trend.

Raising rates strengthens the
currency, something India badly needs to do. India’s
foreign exchange problems are well known and need not be elaborated here. At a time when the country is trying to
attract foreign capital by opening up new sectors for foreign investment, what
justifies discouraging domestic savings?

Lowering interest rates now will worsen these trends, causing a further rise in inflation, erosion of savings, flight of deposits from the banking system and weakening the currency.

Vested interest and sheer
ignorance promotes the myth that somehow low
interest rates are ‘good’ and high rates ‘evil’. The debate in the mainstream media is so one-sided that the merits of raising the rates or keeping them high are not even discussed. The bogey of low
industrial growth and high Non-Performing Assets (NPAs) is raised every time to
oppose raising or justify lowering the rates. But industrial growth has been slow mainly because inflation is eating away into people’s savings, leaving people
with little money to spend on other things. High NPAs have been a result of various
factors like the policy mess (e.g. power sector), poor business plans (e.g.
aviation) or simply, in the words of the Finance Minister himself, “poor lending decisions”,
not to mention willful defaults and corruption (e.g. real estate). I have not come
across any instance which points to high interest rates as the primary cause of
an asset turning bad. The rates simply aren’t that high.

If high interest rates are not
a cause of the problem, lowering them cannot be the solution as well.

The villagers of Lalpur Karuata, like the rest of us, will soon know whether Subbarao keeps his promise.

Neither does paper money! Let us first look at some more points of data (Figure 3). It is known that all Central Banks are holding large reserves of Gold as part of their foreign currency reserves. The adjacent table that shows that even
those countries who are facing severe economic stress, are holding large amounts of gold as part of their foreign exchange reserves. (Even China is playing catch up and is in fact set to emerge as the world’s largest gold importer)

Fig. 4: Central Banks have become net buyers in Gold in recent years

Not only are the Central Banks holding large quantities of Gold, but are increasing them further (see Figure 4). In 2012 too, Central
Banks have remained net buyers of the yellow metal, as these reports suggest (click here or here). If gold had no intrinsic value, why are the Central Banks themselves, who
supposedly understand money better than us, sitting on so much gold
and buying more?

The fact is, Central Banks understand that gold is
money, and money does not have intrinsic value. Your currency note derives its
value from the promise of the Central Bank printed on it. Gold derives its
value from the value attached to it by thousands of years of human civilization.
To destroy value of paper money, you just need to print more money (to
elaborate on this is beyond the scope of this article, but the interested
reader can refer to this excellent article on inflation). To destroy value of gold, you need to change the subjective opinions of
billions of people (and Central Banks) all over the world. The reader can
decide what is easier.

Even India's Central Bank, which itself bought 200 tonnes of gold in 2009 had this to say last week: "Gold is easily accessible. It is a store of value, has no credit risk and is relatively liquid thereby incentivising many households to buy gold” (RBI's Financial Stability Report
(FSR) released on 28th December 2012).

But gold has no cash flows, pays no interest or dividends and is risky to store.

A common argument made against gold, but gold is not an equity
share at all. So aren't we comparing apples with oranges here? Gold is not an investment at all. Gold is money, gold is currency, gold is wealth. I would use the cash flow argument only to evaluate an equity
share, not gold.

But of course, you can’t
take a milligram of gold to the grocer to buy your stuff, right?

Right. Nobody disputes the need
for paper (or digital, these days) money. This article should not be construed
as an invesmtent advice, nor am I saying that gold prices will continue to rise
perpetually. The purpose of this article is only to highlight that gold imports are nowhere as problematic as they are being made out to be and one needs a
different perspective to understand gold.

Conclusion

It is estimated that Indian
households own more than 17500 tonnes of gold accumulated over centuries of
civilization. Despite two decades of economic reforms, it is pointed out that India’s equity investor population has actually shrunk – a surprising statistic given
the importance the stock markets are attached to by policy makers and the media. Performance of mutual funds has been disappointing, to say the least, and double
digit inflation has made investing in fixed income instruments a loss making proposition. Gold and property are the only assets
where Indian people have seen their wealth grow. Since buying property needs deep
pockets, gold has emerged as the only asset which people can accumulate in
small quantities. In fact, in the FSR mentioned earlier, the RBI has admitted low interest rates have caused households to shift away from financial assets to physical assets and valuables such as gold. “Gold prices have increased the most in comparison with other assets and are significantly above the movement in WPI (i.e. inflation)” it said. It has proposed inflation indexed bonds as an option, which it hopes can reduce demand for gold.

Blaming gold imports suits the
political class, as it shifts the blame of India’s
economic ills away from its own mismanagement to the Indian public. But it is
for us to analyze data, ask the right questions and
make intelligent judgement. Gold imports are neither frighteningly high, nor
the cause of India's currency problems. Nor are Indians alone in buying gold. If people are buying more gold, there are reasons for the same. Those reasons need to be addressed. Other avenues to park money need to be made more attractive. Raising taxes or banning imports
will only encourage smuggling, punishing the honest and rewarding the
dishonest. Key non-gold imports, such as oil or defence need to be reduced by increasing
domestic production. Exports need to be increased by controlling
inflation (since higher domestic costs reduce export competitiveness). Interest
rates need to be increased, and should be higher than inflation rate, in order to encourage
savings in financial assets like bank deposits. Until that happens, people will
continue to buy gold, and for a good reason.

III

President Roosevelt’s order had
permanently pegged the price of 1 oz. of gold at $ 35 and committed the U.S.
government to exchange dollars for gold at this rate with anyone on demand. After
World War II, backed by gold, the U.S. Dollar emerged as the primary currency
of global trade. All international transactions and agreements, no matter
between which two countries and what their currencies, came to be denominated
in U.S.dollars. But thanks to inflation, the dollar continued to lose its value while gold held its own. By the early 1970s, it was
clear that an ounce of gold was much more valuable than the $ 35 that the U.S.
government paid for it. The demands on America to redeem dollars for gold increased
dramatically. In 1971, faced with a run on its gold, President Nixon announced that it was ending the peg of the dollar to
the gold, letting it float freely in international markets. In the next 10 years, the price of gold
shot up more than 10 times to more than $ 400 per ounce and is trading at $ 1650 today.

Saturday, January 5, 2013

On 5th April 1933, citing difficult economic
conditions, the then U.S. President Franklin Roosevelt signed a decree. The Executive Order 6102, as it was called, made it illegal for American citizens
to possess gold (with certain exemptions). The Order specified a date, 1st May 1933 to be precise,
before which all citizens were required to deposit all the gold bullion held by them with
the U.S. Treasury or face heavy penalties and / or imprisonment upto 10 years.
The U.S. Government would pay $ 20.67 per oz (troy ounce, i.e. 31.10 grams, the
then official gold exchange rate) for the gold, the Order said.

A few months after the
Order, the President signed The Gold Reserve Act of 30th January 1934,
outlawing private possession of Gold and suddenly changing the price of gold to $ 35 an ounce. In effect, wealthy Americans, who
had amassed huge amounts of gold over generations of hard work and
entrepreneurship since the onset of American industrialization in the mid-nineteenth century were short cheated for millions of dollars by
the government in the name of saving the country. Mind you, financial markets were not as well developed in those days as they are today, and gold was one of the primary means of wealth accumulation in the U.S. at that time.

Over the last few months, there
has been a sustained campaign in the press about India’s
‘soaring’ gold imports. The government has raised taxes dramatically on gold, quadrupling the import
duty rate, changing it from specific to ad valorem, and doubling the
excise duty on jewellery as well. “One of the primary drivers of the
current-account deficit has been the growth of almost 50 percent in imports of
gold and other precious metals in the first three quarters of this year,” Mr. Pranab Mukherjee, the then Finance Minister had said earlier last year, before announcing the tax hikes. “I have been
advised to strengthen the steps already taken to check this trend.” To cut a long story short, Indians are buying too much Gold, and that is
causing problems in managing the economy, we are being repeatedly told.

It is therefore time to take a look at the numbers and check out the facts. Take a look at the data on gold imports given in figure 1 below:

Fig. 1: Ninety percent of India's imports are non Gold

We observe that:

1. Gold imports were 9.26 % of India’s
total imports in 2011-12. Ninety percent of India's imports are other than gold.

2. Imports were in the 5 – 6 %
range till 2008-09 but increased after that, roughly the time when the rapid
deterioration of the economy began.

3. There has been a dramatic
increase in the price of gold in the last decade. Increase in the quantity
of gold imported therefore, is more benign. (It is in the range of 7 - 8 % per annum)

Gold imports have thus increased only in line with the overall growth of the economy, with only a small uptick in the last 2-3 years. They are in fact expected to come down in the current year and the next. The brouhaha around gold imports therefore does not seem justified.

Don’t they cite some data whenever they blame gold imports?

Figure 2: India's CAD started deteriorating from 2004-05 itself

Most of the time, it is pointed out that gold imports are high as a percentage of Current Account Deficit (CAD,the excess of total imports to total exports). Read the Finance Minister's comment yesterday: ‎“Suppose gold imports had been one half of the actual level that would have meant that our ‎foreign exchange reserves would have increased by $10.5 billion,” Chidambaram said. “I would ‎therefore appeal to people to moderate the demand for gold, which leads to large imports of ‎gold.”But this is a wrong metric
to use, since it does not prove causation. As Figure 2 shows, India’s
current account started deteriorating as far back as 2004-05 itself, much before gold imports picked up. Current
account deficit is caused not just by gold imports, but by allimports
and all exports. The question is not why gold imports are rising, but why
the CAD is rising. Contribution of gold imports to current account
deficit is much smaller than what is made out to be. In 2011-12, India's total imports were USD 607.158 billion and total exports were USD 529.003 billion. Gold imports were thus only 4.95 % of the total Foreign Trade of USD 1,136.161 billion, a very small portion, compared to other imports like petroleum or defence. Overall current account deficit on the other hand, has increased at 64 % p.a. in the last 7 years.